Monetary Policy

What is monetary policy?

Monetary policy is the set of actions a country’s central bank uses to manage the money supply and influence economic activity. Common objectives are stable prices (low inflation), maximum sustainable employment, and orderly financial markets. Typical tools include adjustments to interest rates, reserve requirements, and open market operations.

Key points

• Controls the overall money supply to support economic growth and price stability.
• Implemented by a central bank (e.g., the Federal Reserve in the U.S.).
• Generally categorized as either expansionary (stimulate activity) or contractionary (restrain activity).
• Main tools: open market operations, policy interest rates (discount rate or similar), and reserve requirements.

How monetary policy works

Central banks influence borrowing, spending, and saving by changing conditions for financial institutions and markets:

• Interest rates: Raising policy rates makes borrowing more costly, which typically slows spending and reduces inflationary pressure. Lowering rates makes credit cheaper, encouraging borrowing and investment.
• Open market operations (OMO): Buying government securities injects liquidity and lowers short-term interest rates; selling securities withdraws liquidity and raises rates.
• Reserve requirements: Changing the fraction of deposits banks must hold alters how much they can lend—lower requirements expand lending capacity; higher requirements constrain it.

Types of monetary policy

• Expansionary — used during slow growth or recession. Central banks lower interest rates and increase liquidity to encourage borrowing, investment, and hiring.
• Contractionary — used to cool an overheating economy and tame inflation. Central banks raise rates and reduce money supply to slow spending and price increases.

Goals and economic effects

• Inflation control — Contractionary measures reduce money flow and demand to lower inflation; expansionary measures can raise inflation if growth outpaces capacity.
• Employment — Expansionary policy tends to reduce unemployment by supporting demand and business expansion; contractionary policy can increase unemployment as activity slows.
• Exchange rates — A larger money supply or lower interest rates can weaken a currency, while tighter policy or higher rates can strengthen it, affecting trade competitiveness.

Monetary policy vs. fiscal policy

Monetary policy is implemented by a central bank and primarily manipulates money supply, interest rates, and liquidity. Fiscal policy is set by the government and uses taxation and public spending to directly influence aggregate demand. Both tools can be used together to stabilize the economy, as seen in major crises when central banks and governments coordinated responses.

Decision process and frequency

Policy decisions are typically made by a central bank committee that meets regularly (e.g., the U.S. Federal Open Market Committee meets several times a year). Central banks can also act between meetings in response to emergencies or sudden market stress.

Common questions

How does contractionary policy curb inflation?
By raising interest rates and reducing liquidity, contractionary policy lowers demand for goods and services, which eases upward pressure on prices—though it can also slow growth and raise unemployment in the short term.

Why is the central bank called a lender of last resort?
In times of financial stress, central banks provide liquidity to solvent but illiquid banks to prevent runs and systemic collapse, stabilizing the banking system and broader economy.

Bottom line

Monetary policy is a primary tool for managing economic stability: expansionary measures support growth and employment, while contractionary measures control inflation. Its effectiveness depends on timely decisions, coordination with fiscal policy when appropriate, and clear communication to markets.